What is an S Corporation Shareholder's Agreement?

Most S corporations with multiple shareholders should have a written shareholders' agreement in effect for a simple reason. A shareholders' agreement reduces the chance and diminishes the costs of a shareholder intentionally or unintentionally doing something that terminates the S corporation's "S" status.

Fortunately, an S corporation shareholder's agreement doesn't have to be that complicated. You'll want to discuss three issues with your attorney:

Identify the prohibited actions

One of the things that should appear in the shareholders' agreement is a list of actions that individual shareholders agree not to take.

For example, an S corporation shareholders' agreement should document shareholder promises not to sell stock to an ineligible S corporation shareholder (since such a sale would terminate the S corp status).

Consider an indemnity clause

Another common shareholders agreement provision is an indemnity clause.

The indemnity clause in a shareholder agreement might say that if a shareholder does do something that damages an S corporation or its shareholders, that shareholder promises to pay the financial consequences. For example, a shareholder might be on the hook to pay the extra (and possibly very significant) taxes that would accrue because of any accidental or intentional termination of the S corporation's "S" status.

A promise to help with remedies

A final common component of an S corporation shareholders agreement is a promise to assist with any remedies required in case something does happen to foul up the S corporation's "S" status. Here's why. In general, any inadvertent or accidental violation of the S corporation illegibility rules won't matter too much if the S corporation immediately corrects the problem.

For example, if the S corporation finds that one of its shareholders is ineligible shareholder but that shareholder's stock is immediately transferred to an eligible shareholder, the ineligible shareholder's brief ownership would not necessary cause the S corp status to terminate. The shareholders should, therefore, agree to assist and cooperate with an S corporation and with other shareholders in effecting these sorts of remedies.

Do you even need to worry?

One final related note: A well drafted operating agreement for a limited liability company--if the limited liability company always anticipated becoming an S Corporation--may contain language that works as an S corporation shareholders agreement. Similarly, a well-constructed set of corporate by-laws may also contain language that works as a shareholders agreement if the attorney drafting the corporate by-laws knew that an S election was imminent.

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